Wednesday, July 13, 2011

For a Stochastic Jubiliee

Modern economies depend on credit: a credit system moves economic resources from where they are acquired to where they are needed. In most times financial systems do a tolerably good job of this—not as good as they could do (since incentives and prices are often misaligned with needs), but good enough that we allow the system to operate.

But credit systems are inherently unstable. Without going into Minskyan detail, it is enough to say that loans sometimes fail to work out as intended, and that systemic overleveraging and herd dynamics can lead to massive, rogue waves of default. This “can” is actually a “will”: you can be certain that, from time to time, major credit disruptions will occur.

The financial crisis of 2007-8 was such an event. It is not over, as the Eurozone credit overhang builds to a potentially disorderly default. Large scale defaults are dangerous, posing enormous technical management challenges and even greater political-economic ones. The one we are in has been very bad and is sure to get worse. Everything we know about credit systems tells us that it won’t be the last.

What to do?

There is an ancient idea that is almost right. The Book of Leviticus calls for the freeing of all slaves and the annulling of debts every 50 years. Today we would not wait so long to restore freedom, but the idea of a periodic debt annulment is attractive. The big problem is that the biblical solution to annulment risk is not practical. God, at this early stage of economic analysis, thought that it would be possible to price in the risk, so that implicit interest rates would rise as the jubilee year approached. Clearly this is wrong. With a fixed date for wiping out debt obligations, the economy would come to a standstill many years in advance.

The solution is obvious: rather than fixing a date for the jubilee, it should be a random draw with a 2% chance in any given year. This would necessitate an additional 2% risk premium on all contracts—a burden to be sure, but one that is bearable, especially since monetary authorities could compensate in part by targeting lower policy rates than they do at present. (This expedient falls short in a liquidity trap, but such a trap would be far less likely if debt overhangs were periodically drained via jubilees.)

It would be an interesting empirical project to simulate a global stochastic jubilee using data from, say, 1950 from the present. Suppose the 2% draw were introduced at the beginning of this period, and suppose, for the sake of simplicity, that monetary authorities were able to fully offset its interest rate effect so as to neutralize its impact on the real economy. Do a Monte Carlo to see the impact of different jubilee dates on the debt accumulation profiles of the runs compared to that which actually occurred. How would these differences have altered the consequences of crunch points like 1982, 1997 and 2007?

One way to think about the agonizing negotiations taking place in Europe today is that they are attempting to work out the dimensions and modalities of a partial jubilee in real time under crisis conditions. Wouldn’t it be a lot easier to work out a preventive system that operates routinely and, except for its timing, predictably?

2 comments:

We already had the "jubilee". It happened while the FED created 8 to 10 trillion dollars to "bail out" the debtors that were over leveraged. And now we need to "finance" that bailout after the fact. We do that by reducing the value of the currency. Why do people insist on trying to forecast the monetary future???? The monetary system can be dealt with in real time in the here and now. It is just like health insurance. There is no reason to GUESS!!! We _KNOW_ how many people have butt cancer and how much it will cost. We CREATE the money to deal with it. And all the people who "have money" pay a fair share of the costs. The people who have no money and who live by serving others will pay none of the costs.

This places responsibility where it belongs. Those who wish to "save up" lots of money will become quite concerned with regulations to prevent a repeat of the financial blowout. We will all be very supportive of the actions of government to find a way to prevent butt cancer. The function of government is to "promote the general welfare". If the "provide for the common defense" does not "promote the general welfare" (which it does) then it should be abolished.

Re: "they are attempting to work out the dimensions and modalities of a partial jubilee in real time under crisis conditions. Wouldn’t it be a lot easier to work out a preventive system that operates routinely and, except for its timing, predictably?"

Yes, prevention would be good. One that operates routinely would appear to post great moral hazard problems. Who gets to choose which entities are subject to debt jubilee? How is bad fiscal and financial policy prevented?

What is the impact of the expansion of credit on the real environment? How much, and what 'type' of credit can you give in a world that is falling apartvery quickly?